After a brief break in March, the broader stock market is buzzing again

In March, inflows had slowed after mutual funds suspended lumpsum payments into select schemes in the backdrop of regulatory scrutiny.

Benchmark midcap and smallcap indices hit record highs on Wednesday, with their valuations now at a five-year high. The Nifty Smallcap 250 index is up 20% so far in 2024, while the Midcap 100 has gained 18%. The Nifty Midcap 100 is trading at a price-to-earnings multiple of 41.59 times, against its five-year average of 35.76, while the Nifty Smallcap 250 has a PE ratio of 33.03 compared with its five-year average of 28 times.

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Despite the market exuberance, there are promising opportunities in mid and smallcaps, said Taher Badshah, CIO at Invesco Mutual Fund. He said some sectors will hold a strong appeal over the next two-three years. The potential for long-term growth and upside remains significant regardless of whether investors enter the market now or wait until after the budget, he added.

While valuations look stretched, growth may be supported by earnings, apart from sustained inflows. For FY26, Nifty Midcap and Smallcap index earnings are expected to be in the range of 22-25%, according to Bloomberg estimates. Any downgrade in earnings might prompt a sharp correction in these indices.

In March, midcap schemes' inflows cooled to ₹1,018 crore from ₹2,061 crore and ₹1,808 crore in January and February respectively, while smallcap schemes saw outflows of ₹94 crore compared with inflows in January, February, April and May, said Abhilash Pagaria, head of Nuvama Alternative & Quantitative Research. Midcap schemes' inflows in May crossed the record set in January. “This clearly reflects the underlying confidence among investors, and (small and midcap) and flexicap will remain the favourite categories," Pagaria said.

More legs to the rally?

Though the rally has raised valuations and the possibility of volatility, some experts anticipate growth opportunities and scope for upside in parts of the midcap and smallcap space.

Sandeep Raina, executive vice-president for research at Nuvama Professional Clients Group, agreed that valuations are on the higher side, adding growth will address this concern.

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“However, we need to look for those sectors which are in the growth phase and stocks that are relatively cheaper," he added. “We should enter the market because timing the market is not what I would suggest."

Raina said the only strategy is to buy in a staggered way that would neutralize the impact of volatility. Also, when entering the market, more weightage should be given to company earnings as that is what matters in the long run, he pointed out.

Sectors that could steal the spotlight

Some experts have identified consumption companies in retail, apparel and pharma as potential bets in the midcap and smallcap space.

According to Vipul Bhowar, director of listed investments at Waterfield Advisors, the government's focus on sectors such as railways, defence and shipbuilding, which predominantly consist of midcap and smallcap companies, is expected to support growth.

“Therefore, while mid/smallcaps have a lower margin of safety compared to largecap stocks, there is potential for continued growth in these sectors, although it may be more volatile," Bhowar said. He said healthcare and housing are promising, and anticipates more initiatives during the budget.

Apart from these, Bhowar said the long-term focus will be on sectors such as automotive and auto components, financial services, infrastructure development, renewable energy and sustainability, and export-oriented sectors.

The risks to the market fervour

Even though midcap and smallcap stocks have the potential to spawn superior returns over a longer time frame, short-term volatility cannot be ruled out, said Vinit Sambre, head of equities at DSP Mutual Fund, while noting some potential triggers for minor corrections.

Now that the election verdict is in, nuances such as potential coalition risks could affect the market, including midcap and smallcap stocks, Sambre said.

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Besides, the midcap and smallcap space enjoys the highest ever returns on equity at this juncture and any dent in the visibility of company growth may prompt a correction, he said. Among global factors, while the US is working to avoid a recession, a global economic downturn and geopolitical conflicts may act as sentiment dampeners.

Sambre said a deep cut in the midcap and smallcap space is unlikely, but he expects high volatility and occasional dips along the way.

Bhowar of Waterfield Advisors said, “Changes in the capital gains tax structure, increasing geopolitical tensions, and stricter Sebi norms may cause selling as investors become increasingly risk-averse."